CLO Issuance Jumps as U.S. Managers Bet on Volcker Rule Verdict

Federal Reserve Chairman Janet Yellen said last week that clarification on how the Volcker Rule
treats collateralized loan obligations would be coming
“reasonably soon.” Managers of the funds that package junk-rated buyout loans aren’t waiting to find out.

The Volcker Rule prohibits banks from investing in a CLO if
the fund owns bonds. After issuance fell to a 17-month low in
January, firms including CIFC Corp. (CIFC) raised CLOs this month
either by getting rid of the option to purchase bonds or
preserving the right to do so, according to people with
knowledge of the deals, who asked not to be identified because
the terms are private.

To ensure compliance, CLO managers have three different
structures they can use on new deals as issuance in the first
two weeks of the month surpassed all of January, which saw a
slump driven by a lack of clarity about the final shape of the
Volcker Rule. Members of Congress sent a letter Feb. 12 to the
different regulators expressing “support” for guidance on the
rule and how it will be applied to CLOs.

“We do not like giving up the optionality, if and when
bonds are cheap again, but if that is what it takes to do a
deal, we are willing to consider” eliminating the bond-investment option, John Fraser, managing partner at 3i Debt
Management U.S., the U.S. debt-investment arm of London-based
buyout firm 3i Group Plc, which oversees $3.5 billion, said in a
telephone interview.

Declining Issuance

Sales of CLOs plunged 60 percent last month to $2.55
billion, the least since $2.2 billion were issued in July 2012,
according to Royal Bank of Scotland Group Plc. Sales in February
totaled $4.4 billion as of Feb. 18, according to JPMorgan Chase
& Co. Issuance of the funds had surged 49 percent last year to
$82 billion.

Morgan Stanley is forecasting a decline in issuance this
year because of Volcker’s current limitation on bank
participation in CLOs. Banks own about $70 billion of CLO debt,
according to the Loan Syndications and Trading Association.

Leveraged loans held in CLOs are “crucial” for leveraged
borrowers, Elliot Ganz, general counsel at the LSTA, said in a
telephone interview. “They are pretty much the only source of
funding for many of these companies.”

The availability of funding has helped to keep the monthly
global speculative-grade default rate at the lowest level since
February 2012, according to Moody’s Investors Service.

Yellen’s Hope

In a House Financial Services Committee hearing on Feb. 11,
when asked by Spencer Bachus, an Alabama Republican, what
additional information she would need to “resolve the CLO issue
and clarify how legacy securities will be treated under
Volcker,” Yellen said regulators are “jointly engaged in
looking” at the issue and she will “hopefully” have a
response soon.

Fed Governor Daniel Tarullo said at a House Financial
Services Committee hearing Feb. 5 that the proposed treatment of
CLOs is “already at the top” of an interagency group’s agenda.
Distinctions between which securities can be included in a CLO
under the rule could be worked out in the implementation, he
said.

“You have clear bipartisan support, the agencies have
admitted that CLOs are an issue and have told us they are at the
top of their list; all of those things put together gives me
hope,” Ganz said.

CLOs, a type of collateralized debt obligation that pool
high-yield, high-risk loans and slice them into securities of
varying risk and returns, were the largest buyers of leveraged
loans last year, with a 53 percent market share, according to
the New York-based LSTA.

Non-Loan Collateral

To comply with the Volcker Rule, new-issue CLOs will either
eliminate their ability to buy bonds or include the option,
which they can’t exercise without a regulatory change, according
to Paul Watterson, co-head of the structured products and
derivatives group in New York at law firm Schulte Roth & Zabel
LLP.

Deals priced after the rule was released in December may
add language that allows investments in non-loan collateral if
the manager obtains written advice from a nationally-recognized
law firm stating the deal won’t be considered a covered fund
under Volcker, Ken Kroszner, an RBS CLO analyst in Stamford,
Connecticut, said in a telephone interview.

This option, sometimes referred to as a springing-bond
bucket or a securities-basket trigger, may be set up so that if
the Volcker Rule is changed or flexibility is added that allows
CLOs to hold bonds, managers will have the ability to do so, he
said.

Preserving Options

“The news in Washington was relatively positive, so if you
are putting together a new CLO and you like securities baskets,
even if they are not a big part of a deal, you certainly want to
preserve your optionality,” Ganz said.

Managers including CIFC and Leon Black’s Apollo Global
Management LLC, the New York-based private-equity firm,
eliminated the ability to invest in bonds in recent CLOs, the
people said.

Charles Zehren, a spokesman for Apollo at Rubenstein
Associates, declined to comment. John Wu, head of structured
products at CIFC, also declined to comment.

A third option is to issue a CLO under Rule 3a-7 of the
Investment Company Act of 1940, which in the past was more
frequently used for balance-sheet deals rather than typical
arbitrage CLOs, according to Cynthia Williams, a partner at
Dechert LLP in Boston and co-head of the firm’s CLO group. Under
3a-7, a CLO may not acquire or sell an asset for the primary
purpose of recognizing gains or decreasing losses.

Bond Bucket

“If managers are prepared to live with that restriction,
Rule 3a-7 is an avenue that CLO issuers may want to explore if
they do not want to be a covered fund under Volcker and want to
include a bond bucket in their deals,” Williams said in a
telephone interview.

Some managers have invested in bonds to increase yields,
3i’s Fraser said. “Not having a bond bucket will have an impact
on how a manager approaches portfolio management,” he said.

The increased yield from bonds may also help replace some
of the interest income lost by companies refinancing at lower
rates, Fraser said.

On Jan. 29 the Fed left unchanged its statement that it
will probably hold its target interest rate near zero “well
past the time” that unemployment falls below 6.5 percent.

Driven by demand from CLOs and retail funds, speculative-grade companies cut interest rates on $272.4 billion of loans in
2013 through Dec. 13, according to Standard & Poor’s Capital IQ
Leveraged Commentary and Data. The average yield on loans issued
by U.S. companies in December was 5.1 percent, down from 6.4
percent during the same month in 2012.

After four years of increasing issuance, deal volume may
fall in 2014. The market for funds backed by widely syndicated
loans in the U.S. peaked in 2007 at $91.1 billion, according to
Morgan Stanley data.

Wells Fargo & Co. (WFC) forecasts issuance of $60 billion in the
U.S. in 2014 and Morgan Stanley cut its forecast to between $55
billion and $65 billion, from as much as $75 billion.

“If Volcker is as strict as possible and limits bank
participation in AAA CLOs,” the rules “could further limit new
issuance,” Kroszner said.